CONNECTING FINANCE AND NATURAL CAPITAL A SUPPLEMENT TO THE NATURAL CAPITAL PROTOCOL SECRETARIAT:

Transcription

1 CONNECTING FINANCE AND NATURAL CAPITAL A SUPPLEMENT TO THE NATURAL CAPITAL PROTOCOL SECRETARIAT:

2 CONNECTING FINANCE AND NATURAL CAPITAL FINANCE SECTOR SUPPLEMENT Table of Contents Foreword 1 Orientation 2 Document structure 2 Finance activities covered 4 Audience 4 1 FRAME STAGE Why? What is natural capital? The relationship between the finance sector and natural capital Natural capital-related risks and opportunities What do natural capital assessments offer? Actions Outputs Case Studies 15 2 SCOPE STAGE What? Decide the objective Identify the target audience Define the scope Actions Outputs Case studies 32 3 MEASURE AND VALUE STAGE How? Measure impact drivers and/or dependencies Measure changes and trends in natural capital Conduct valuation Actions Outputs Case studies 52 4 APPLY STAGE What next? Collate results Validate and/or verify findings Disseminate results and take action Actions Outputs Case studies 64 5 Annex 1: Examples of valuation techniques 66 Glossary 70 References 71 List of figures 74 List of tables 74 List of boxes 75 Acknowledgments 76

3 Foreword by Mark Gough, Natural Capital Coalition; Marie Morice NCFA; and Angelique Laskewitz, VBDO If we told you that we could supply you with information that was essential to your portfolio, that would provide competitive advantage, and generate benefits to society and the environment, we are sure that you would all be interested in getting it. You would also probably be confused as to why this essential information was not already available to you. Our relationship to the natural world (or natural capital) is, for the majority of the time, invisible in our decision making, and yet the companies that that we lend to, invest in and provide risk cover for, both depend and impact on it. The realization of these impacts and dependencies is growing, and leading companies in the corporate sector are now carrying out natural capital assessments to understand their risks, identify opportunities, and make better informed decisions. Financial institutions are beginning to also recognize the gap in their information sources and the indirect impacts and dependences they have through their banking, investment and insurance activities. There are some examples of excellence and a growing number of initiatives in this space, including the Principles for Responsible Investment, Environmental, Social, Governance (ESG) indicators and indexes, and the Sustainable Development Goals. Natural capital approaches can enhance these by providing a clear framework to ensure that non-financial information is meaningful, robust, and pertinent for financial decision makers. It builds on existing processes, and encourages wider discussion around moving from impact to dependency, from measurement to valuation, from stocks to flows and from separate issues to a systems approach. It can help us to balance short term goals with long term resilience. The Natural Capital Protocol has created a globally recognized and standardized framework for business. This supplement to the Protocol, aims to connect finance and natural capital in the same way, and to create a common language across business, government, civil society and finance on this important topic. We have been extremely lucky to have so much input, not only from within the finance community, but also the influencers and enablers of the financial system. The Supplement has been developed collaboratively, through consultation and engagement with many different stakeholders to develop a widely accepted, scientifically robust, and useful guidance. Hopefully this Supplement will inspire debate and conversation, start disagreements and lead to innovation. It is just a piece of paper at the moment, albeit with the input of many experts in the space, but it now needs to be turned into reality. Please read, apply, test and improve what is written here, and then share your experiences with others so we can continue to learn together. Mark Gough Executive Director, Natural Capital Coalition Marie Morice Director, Natural Capital Finance Alliance Angelique Laskewitz General Director, Association of Investors for Sustainable Development (VBDO). The Natural Capital Coalition is a unique global multi-stakeholder collaboration that brings together leading initiatives and organizations to harmonize approaches to natural capital. The Natural Capital Finance Alliance (NCFA) is a collaboration between the UN Environment Programme Finance Initiative (UNEP-FI), Global Canopy and the finance sector which works towards the integration of natural capital considerations into financial decision-making. The Dutch Association of Investors for Sustainable Development (VBDO) represents private and institutional members who consider it important that the companies in which they invest are socially responsible. References Apply stage: What next? Scope stage: What? Frame stage: Why? Introduction Measure and value stage: How? Annex 1: Examples of valuation techniques 1

4 Orientation Orientation Financial institutions are largely aware that sustainability or environmental, social, and governance (ESG) issues can create risks for their banking, investment, and insurance outcomes. These institutions are also increasingly recognizing opportunities from active consideration of ESG factors. Even so, taking action can be complex and challenging. The consideration and assessment of nature as a form of capital provides a systematic way to improve financial institutions identification and management of natural capital-related risks and opportunities. The approach builds on existing ESG practices and translates commitment into action by helping to generate trusted, credible, and actionable information that can be used to inform decisions. Document structure This Supplement is based on the framework of the Natural Capital Protocol, a standard decision-making process written for business, made up of four stages covering why, what, how, and what next. This document builds on the Protocol, providing sectorspecific guidance to make the Protocol more applicable and practical for financial institutions. In the Supplement, each Stage asks specific questions and provides guidance on how to answer them. At the end of each Stage is a list of typical outputs (see figure 0.1). Box 0.1 The Natural Capital Protocol The Protocol is a standardized framework for business to identify, measure, and value their direct and indirect impacts (positive and negative) and dependencies on natural capital. It is designed to help generate trusted, credible, and actionable information that business managers need to inform decisions. You may find it helpful to refer to the Natural Capital Protocol and supporting information available on the Natural Capital Hub for additional background, methodological detail, and greater depth around natural capital thinking. 2

5 Purpose Outputs FRAME Why? The Frame Stage helps you establish why you would conduct a natural capital assessment A business case for why undertaking a natural capital assessment is relevant for your institution Knowledge of how a natural capital assessment can benefit your institution Potential types of analysis and uses of their results The Scope Stage helps you define what should be included in your assessment A clear objective for your assessment An agreed target audience(s) A defined scope including: Overall focus of the assessment Focus on impacts and/or dependencies Value perspective Boundaries SCOPE What? What is material MEASURE AND VALUE How? The Measure and Value Stage guides you through how to measure and value natural capital A list of indicators Data for each indicator or, where data are not available, a plan for addressing the data gap An understanding of the changes and trends in natural capital relevant to your institution A comprehensive valuation of relevant natural capitalrelated costs and benefits, whether in qualitative, quantitative, and/or monetary terms A full record of key assumptions, sources of data, and methods used Figure 0.1 Key questions and outputs for each Stage of the Supplement APPLY What next? The Apply Stage helps you interpret your results and identify what next Clarity on caveats, assumptions, and uncertainties Validation and/or verification of process and results Key messages for internal and external communication Agreed actions you will take References Apply stage: What next? Scope stage: What? Frame stage: Why? Introduction Measure and value stage: How? Annex 1: Examples of valuation techniques 3

6 Orientation Finance activities covered This Supplement covers banking, investment, and insurance activities within the finance sector, with a specific focus on the following activities: Banking: Project finance, corporate lending, and underwriting Investment: Investment across the range of asset classes (e.g., equities, corporate bonds, sovereign bonds, property, private equity, infrastructure), active ownership (engagement), and impact investing Insurance: Corporate underwriting and reinsurance, with investment management activities covered under investment The Supplement provides a framework for financial institutions to assess the natural capital impacts and dependencies of the entities and portfolios that they support. These impacts and dependencies represent an indirect relationship to natural capital on the part of the financial institution. If you are looking to identify, measure, and value your institution s direct impacts and/or dependencies (e.g., office materials, travel, and energy use), you should apply the Natural Capital Protocol rather than this Supplement. Audience This Supplement is aimed primarily at ESG analysts, environmental managers, responsible investment managers, due diligence specialists, risk managers, analysts, and portfolio managers working in financial institutions. Natural capital thinking can play an important role in informing strategic decisions, and it is therefore important to engage across the financial institution. 4

7 Frame stage FRAME STAGE Why? The Frame Stage helps you establish why you would conduct a natural capital assessment. The Frame Stage introduces concepts such as natural capital, ecosystem services, and natural capital impacts and dependencies. The stage explains how these concepts can pose risks and opportunities to the finance sector, and why a natural capital approach can help identify and manage them. Stage Sections 01 Frame stage 1.1 What is natural capital? 1.2 The relationship between the finance sector and natural capital 1.3 Natural capital-related risks and opportunities 1.4 What do natural capital assessments offer? 1.5 Actions 1.6 Outputs 1.7 Case Studies References Annex 1: Examples of Measure and value Apply stage: What next? Scope stage: What? valuation techniques stage: How? Frame stage: Why? Introduction 5

8 Frame stage 01 Frame stage 1.1 What is natural capital? Glossary Natural capital: the stock of renewable and non renewable natural resources (e.g., plants, animals, air, water, soils, minerals) that combine to yield a flow of benefits to people (Natural Capital Coalition 2016a). Ecosystem: A dynamic complex of plants, animals, and microorganisms, and their non-living environment, interacting as a functional unit. Examples include deserts, coral reefs, wetlands, and rainforests (MA 2005). Ecosystems are part of natural capital. Ecosystem services: The most widely used definition of ecosystem services is from the Millennium Ecosystem Assessment (MA 2005): the benefits people obtain from ecosystems. The MA further categorized ecosystem services into four categories: Provisioning: Material outputs from nature (e.g., seafood, water, fiber, genetic material). Regulating: Indirect benefits from nature generated through regulation of ecosystem processes (e.g., mitigation of climate change through carbon sequestration, water filtration by wetlands, erosion control and protection from storm surges by vegetation, crop pollination by insects). Cultural: Non-material benefits from nature (e.g., spiritual, aesthetic, recreational, and others). Supporting: Fundamental ecological processes that support the delivery of other ecosystem services (e.g., nutrient cycling, primary production, soil formation). Abiotic services: The benefits arising from fundamental geological processes (e.g., the supply of minerals, metals, oil and gas, geothermal heat, wind, tides, and the annual seasons). Biodiversity: The variability among living organisms from all sources including, inter alia, terrestrial, marine, and other aquatic ecosystems and the ecological complexes of which they are part; this includes diversity within species, between species, and of ecosystems (UN 1992). Natural capital is the stock of renewable and non-renewable natural resources (e.g., plants, animals, air, water, soils, minerals) that combine to yield a flow of benefits to people. These benefits are commonly known as ecosystem services or abiotic services (see glossary left). Natural capital underpins our societies, economies, and institutions and regulates the environmental conditions that enable human life. We use the term capital as a metaphor. Natural capital is not a fungible asset like financial capital. It is instead a way of describing our relationship with nature and measuring and valuing nature s role so that we can include it in decision-making. STOCKS Natural capital Biodiversity FLOWS Ecosystem and abiotic services VALUE Benefits to business and to society Figure 1.1 Natural capital stocks, flows, and value (Natural Capital Coalition 2016a) Financial institutions often look at the environment through specific issues, such as water, waste, biodiversity, forestry, and climate change. There is a common misconception that natural capital concerns only biodiversity, but in fact natural capital includes all of these environmental issues and binds them together, including climate change. Biodiversity is nevertheless critical to the health and stability of natural capital as it provides resilience to shocks, like floods and droughts, and supports fundamental processes such as the carbon, nitrogen, and water cycles as well as soil formation. Therefore, biodiversity is both a part of natural capital and also underpins the services that natural capital provides. Natural capital thinking provides financial institutions with more in-depth understanding of the interconnections and trade-offs between all environmental issues. The concept of natural capital broadens the conversation to include dependencies, as well as impacts, and considers value, in addition to measurement alone. Understanding the value of both natural capital impacts and dependencies helps financial decision makers to understand the significance of these issues to their institution, and therefore make more informed decisions. This leads to greater insight on the reliability and resilience of financial returns, and the associated natural capital risks and opportunities for the institution. 6

9 1.2 The relationship between the finance sector and natural capital Financial institutions support entities (including public and private organizations, projects, activities, assets, financial instruments, etc.) through their banking, investment, asset management, and insurance activities. These entities interact either directly or indirectly with natural capital. This can be through production inputs (raw materials, water, energy), or a dependency on the services that nature provides (regulating services such as pollination, supporting services such as nutrient cycling, or cultural services such as recreation). The conceptual model (figure 1.2) illustrates these interactions. ENTITIES FINANCE SECTOR Including government and people Figure 1.2 Conceptual model for natural capital and the finance sector Entities serviced by the finance sector impact and depend on natural capital. These impacts and dependencies deliver both costs and benefits to the entities (e.g., via operational production inputs, regulated emissions, license to operate) and to society (e.g., via recreational utility of landscapes, positive or negative health impacts, loss or preservation of species). In turn, these costs and benefits create risks and potential opportunities, which are transferred to the financial sector through banking, insurance products, and investments such as corporate bonds, stocks, and financial derivatives. For example, a bank may lend money to an agricultural business. The agri-business may take actions to reduce soil erosion on its land (positive impact), leading to increased yield (benefit), thus enhancing the ability of the business to service its debt. This, in turn, improves the credit quality of the bank s portfolio (lower risk). A further example relating to soft commodities and natural capital risk can be found in box 1.3. As the conceptual model shows, the finance sector also interacts with and depends on society, which includes government and people. Society provides the foundational enabling conditions necessary for the finance sector to exist, the social license to operate, to which finance responds by providing support and services (such as retail banking) to society. Government plays an important role in framing the enabling conditions for a stable economy by setting regulations and directing finance through the creation of market incentives which can stimulate the integration of natural and social capital into market decisions. Government also has the potential to influence market distortions which can affect financial decision making, see Box 1.1. These societal and policy-making factors are very important, but they are outside of the scope of this Supplement, which focuses on financial services provided to entities. 7 References Annex 1: Examples of Measure and value Apply stage: What next? Scope stage: What? valuation techniques stage: How? Frame stage: Why? Introduction

10 Frame stage Box 1.1 Market failures and distortions: focus on externalities and subsidies Significant market failures are often directly connected to externalities ; an externality is the cost or benefit that affects a party who did not choose to incur that cost or benefit. Market failures include: Imperfect competition (e.g., when there is concentrated market power from monopolies). Missing markets (e.g., public goods, such as defense, education, and health, or situations where there are no property rights). Market distortions (i.e., where the government intervenes in the market, including in situations where it acts to address other market failures and/or to improve the equity of resource distribution). Market distortions include the following policies: Taxes: These can be applied to change behavior and raise revenues (e.g., a tax on pollutants can help overcome the problem of negative externalities). Subsidies: These are typically used to increase the production of a certain type of good (e.g., to support agricultural production of certain crops or help reduce the cost to consumers (e.g., fuel). Price controls: These can be placed on monopolies such as utilities (e.g., water providers). Nationalization: This relates to converting profit-seeking monopolies into nationalized organizations to improve social welfare outcomes. While taxes and subsidies are often well intended, they can often have unintended consequences that result in environmentally damaging activities (e.g., monoculture, clearing of natural habitat, or overfishing). In these situations, they are referred to as perverse subsidies, causing more damage than good on natural capital. When looking to value impacts on society in the Measure and Value Stage, the price of the tax or subsidy should be excluded, as they are transfer payments rather than actual resource-use costs. 8

11 1.3 Natural capital-related risks and opportunities There are many natural capital-related risks and opportunities that are relevant to financial institutions. They can be grouped together under five categories, as shown in table 1.1. Table 1.1: Examples of natural capital-related risks and opportunities for finance Category Operational Relating to entities activities, expenditure and processes, etc. Legal and regulatory Relating to laws, policies, and regulations that affect the activities of both financial institutions and entities Markets Relating to the flow and provision of financial services Reputational Relating to trust and relationships between stakeholders Societal Relating to the relationship between, and consequence for, wider society beyond the institution and entities Examples of natural capital-related risks Increased insurance claims resulting from changes in rainfall and flood patterns. Increased risk of default as a result of entities facing higher business costs due to poor crop yields leading to higher agricultural commodity prices. Reduced valuations due to increased costs for ecosystem services (e.g., higher cost for deeper groundwater extraction). Increased risk of defaults due to higher business costs as a result of changes in water treatment and disposal requirements. Premature write-offs of assets as a consequence of delays due to difficulties in obtaining project permits and licenses. Downward revaluation of assets due to high risk of litigation relating to activities that damage the natural environment or compromise livelihoods. Risk of asset stranding as a consequence of land-use change limitations, constraints on pesticide use, waste generation, etc. Inability to attract co-financiers and/or investors due to uncertain risks related to natural capital. Loss of investment value due to customer boycotts of entities producing products that are seen to have negative environmental impacts. Loss of clients due to a fund s poor environmental performance outcomes (e.g., if a fund has suffered natural capitalrelated write-downs). Damaged reputation as a consequence of negative press coverage related to support of projects or activities with negative impacts on natural capital (e.g., deforestation of rainforest, overfishing). Loss of clients as a result of their perception that the financial institution does not adequately account for natural capital in its decision making. Damage to a local market as consequence of local community protests about the impacts of a project on their ability to access natural capital or related ecosystem services (e.g., pollution of aquifers as a consequence of the operation of a chemical plant). Examples of natural capital-related opportunities New mutual funds that invest in companies offering innovative solutions to natural capital problems (e.g., waste bio-refineries, biodiversity conservation banks). Increased issuance of bonds for green infrastructure projects (e.g., natural flood management solutions). Increased sales of liability and other insurance to cover natural capital-related legal risks. Reduced risk of asset stranding by ensuring that the regulatory risks associated with natural capital are explicitly considered in investment decision making. More timely preparation for investors in adhering to current and potentially stricter future regulation in relation to fiduciary duty. Increased demand for funds that invest in companies that have positive environmental credentials. Enhanced financial performance of investee companies as a result of being able to access new markets and develop new products to meet green consumer demand. The development of new revenue streams from new/emerging environmental markets and products (e.g., carbon offsets, sale of surplus water rights, habitat credits, renewable energy or electric vehicles). Improved reputation as a result of supporting activities that enhance natural capital (e.g., ecosystem remediation or rehabilitation). Positive media coverage for supporting innovative activities (e.g., energy efficiency, circular economy activities). Improved ratings by sustainability/esg analysts. Upward revaluation of assets through ensuring that local communities benefit from activities being supported by the finance sector (e.g., improved recreational access to a managed wetland, improved water quality from a managed water catchment). References Annex 1: Examples of Measure and value Apply stage: What next? Scope stage: What? valuation techniques stage: How? Frame stage: Why? Introduction For further examples, see ACCA, Fauna & Flora International, and KPMG 2012; CISL 2015; UNEP FI 2008; VBDO and CREM

12 Frame stage The classification of climate-related risk and opportunities by the Task Force on Climate Related Financial Disclosures (FSB-TCFD 2017) has strong similarities with the classification presented in table 1.1. The TCFD considers two types of risk: (i) physical risks, similar to operational risk in table 1.1; and (ii) transition risks that encompass the remaining risk categories in the table. TCFD specifically identifies technological risk, which is not identified here as it is considered as a transversal risk across the rest of categories. This Supplement, and the natural capital approach generally, considers the value of natural capital both to the financial institution and to society more generally, it therefore includes a specific category of societal risk, which is not separated out by the TCFD. The TCFD identifies resilience as a source of opportunity, which is aligned with operational opportunities in table 1.1. The other forms of opportunity (resource efficiency, energy source, and products and services) are included within the operational, legal and regulatory, market or reputational typology of opportunities above. Boxes 1.2 and 1.3 discuss additional considerations around natural capital-related risks and opportunities including the relevance to sovereign credit risk (box 1.2) and a sectorspecific perspective (box 1.3). Box 1.2 The relevance of natural capital for sovereign credit risk and bond markets With more than US$ 45 trillion in outstanding government debt (Bank for International Settlements 2016) (figure accurate at time of writing), this asset class is one of the largest in the global economy. Governments are also responsible for the management and stewardship of vast national stocks of natural capital. As countries rely on the resilience and productivity of their natural capital to sustain their economies, their approach to natural capital management may influence financial markets perception of country risk and price of government debt. A growing number of banks and investors are recognizing the need for a broader understanding of emerging risks in bond markets. Natural resources, both renewable and non-renewable, are critical to each nation s economy. Yet, to date, risks stemming from natural resources in particular are not adequately considered in determining the effectiveness of public finance. The Environment Risk in Sovereign Credit (ERISC) initiative (UNEP FI 2016) has developed metrics and methods for quantifying natural resource and environmental risks so that these risks (such as how climate change might impact food production and economic indicators) can be incorporated into sovereign credit risk assessments. One ERISC study found that if environmental risks were quantified and considered, 8 out of 78 countries assessed would experience a downgrade of at least one notch in their sovereign risk rating. Of these, 16 countries would be downgraded by three notches or more. These scenarios provide some early indication that natural capital can affect credit ratings and subsequently affect costs to governments of borrowing money through international capital markets. This has been further supported by reports from the major credit ratings agencies. For example, Moody s has produced an infographic, Climate Change and Sovereign Credit Risk (Moody s 2016), highlighting links between physical climate-related factors and sovereign debt ratings and, through this lens, identifying higher- and lower-risk countries. 10

13 Box 1.3 Soft commodities and natural capital risks: one example from a forest ecosystem Palm oil, soy, and beef are examples of valuable soft commodities that generate significant impacts through degradation of forest ecosystems (e.g., through illegal logging) (note that many soft commodities impact ecosystems, such as seafood taken from marine ecosystems, this box provides only one example). Financial institutions that support soft commodity production value chains (by providing debt, equity, and other forms of capital or trading) can, the consequent degradation of natural capital, therefore suffer exposure to associated risks, such as decreased yields or conflict with local communities. Financial institutions, especially those whose portfolios are significantly exposed to sectors with large direct or indirect impacts or dependencies on forest ecosystems, need to be aware of how this risk may affect financial operations and transactions. For example, from the lending perspective, the loss of forest ecosystems could impact cities and the agricultural sector by reducing provision of clean water, natural plague control, or pollination; it could therefore impede an agricultural client s ability to service its debt and therefore impair the credit quality of the portfolio. On the investment side it may affect valuations, and on the insurance side it may affect risk exposure. Banks, traders, and investment managers have a considerable indirect natural capital footprint by lending to, or investing in, companies involved in unsustainable production, trade, or sale of soft commodities. On the insurance side, association with illegal activities may result in loss of cover, or changes in ecosystem services may change the conditions of crop insurance. It is still difficult to calculate a portfolio s exposure to entities with significant forest footprints, and/or the value at risk from issues such as water scarcity or deforestation impacts. However, the development of soft commodity policies offers a way for banks and investors to better manage this exposure, by managing their lending or investment in assets that potentially have high deforestation impacts. Figure 1.3 shows an example of how soft commodities (in this case forest products) are connected to risks for financial institutions. Financial institutions risks Soft commodity supply chain risks Soft commodity supply chain NON-PERFORMING LOANS Clients may be unable to service debt Operational Resource scarcity, biodiversity loss, and ecosystem degradation leading to decreased productivity and resilience FORESTS Legal and Regulatory Environmental breaches and un-preparedness for compliance ASSET VALUES Assets may become stranded if market conditions change Legal and Regulatory Legal liabilities due to failure to manage environmental and social risks in activities PRODUCERS TRADERS PROCESSORS REVENUE/ PROFITABILITY Market value may deteriorate as revenue and profits are impacted Markets Change in consumption due to changes in societal preferences RETAILERS Reputational Companies might be targeted by campaigns due to their involvement in soft commodity value chains CONSUMERS Risks within soft commodity supply chains can affect standard financial metrics (e.g., revenue, asset valuation, or costs) which can affect credit worthiness of clients, or market value of debt, or equities of investee companies. The soft commodity supply chain includes a diverse range of entities that have either direct or indirect impacts on forests. Figure 1.3 Soft commodities and natural capital risks (adapted from NCFA and UNEP 2015) References Annex 1: Examples of Measure and value Apply stage: What next? Scope stage: What? valuation techniques stage: How? Frame stage: Why? Introduction 11

14 Frame stage 1.4 What do natural capital assessments offer? A number of finance sector initiatives address environmental issues. These include: The Equator Principles UN-supported Principles for Responsible Investment IFC Performance Standards (IFC 2012) Banking Environment Initiative UNEP Finance Initiative UNEP-FI s Principles for Sustainable Insurance UN Environment Inquiry into the Design of a Sustainable Financial System The Dutch Association of Investors for Sustainable Development (VBDO) The Natural Capital Finance Alliance Many financial institutions are already developing and using sustainability/esg tools and methodologies, which can help bankers, insurers, and investors evaluate which environmental risks might affect a company s revenue and costs and how the company is managing those risks. Some financial institutions might look at how companies manage natural capital-related issues such as energy use, waste, pollution, climate change impacts, biodiversity, and natural resource use. The application of a natural capital approach builds on the ESG and risk initiatives already in use, but provides additional benefits, such as those described in table 1.2. Table 1.2: The additional value of a natural capital approach Area Existing approach Additional value of a natural capital approach Impacts and dependencies Valuation Focus on impact Impact and dependencies A focus on the impacts on natural capital, rather A natural capital approach importantly includes than dependencies. Water discharge, waste and a consideration of dependencies (e.g., fiber, carbon are some more advanced issues in minerals, seafood, pollination, climate relation to impact, with concerted efforts to regulation, water regulation, wind), to provide a develop tools and instruments. holistic view of risks and opportunities. Focus on measurement Focus on valuation Many financial institutions are already effectively A natural capital approach provides an measuring environmental aspects of their understanding of what these inputs and outputs banking, investing, and insurance practices. This mean in terms of value to society and value to tends to be focused on measuring quantities of businesses and financial institutions in relation to natural resources used as inputs to production associated impacts and dependencies. This (water, minerals, etc.) or the non-product progression from measurement to valuation is outputs of business activities (emissions, critical in understanding the extent of risk, discharges, etc.). exposure, and opportunity to better inform decision-making. Scope Limited issues Environmental assessments tend to focus on a relatively limited set of natural capital issues (e.g., relatively little attention is paid to regulating services and cultural values). Broader range of issues Able to consider a much wider range of natural capital impact drivers and dependencies, including those which might vary depending on context. Provides increased coverage of regulating services and cultural values. From this broader range, users are then equipped with better information to identify which are the most material. Connectivity Stand-alone Environmental issues tend to be seen as a series of stand-alone issues (e.g., climate change is often analyzed and treated as a distinct issue to water, biodiversity, or public health). The consequence is that relationships between these issues are often missed (e.g., issues of scarcity, multiple uses and trade-offs). Interrelated system Able to treat natural capital as a set of interrelated issues, considering trade-offs and net positions. 12

15 This Supplement builds on work already done by the Natural Capital Protocol. The Protocol is written for businesses and other entities to understand their own impacts and dependencies. The Supplement enables financial institutions to build on the Protocol framework and to make it applicable for their own decision-making. Figure 1.4 illustrates how the natural capital assessment process acts like a continuum, with entities (e.g., businesses) and financial institutions tracking the same path. Entities measure, value, decide, and strategize against their own natural capital impacts and dependencies. These could be shared with supporting financial institutions through public sustainability reporting, or in response to surveys or ratings, or through direct requests. This then allows the financial institutions to build their own understanding on their entities and portfolios, allowing them in turn to measure, value, decide, strategize and disclose if they chose to. Disclosure approaches, e.g., TCFD guidelines, CDSB, CDP, GHG Protocol Strategy approaches, e.g., Climate agreements, PRI, UN Sustainable Development Goals, Equator Principles Strategize Disclose Decide Measure Value Measurement approaches, e.g., GHG Protocol, ESG processes Valuation Valuation technique is dependent upon the decision you want to inform but may include value transfer and hedonic pricing Figure 1.4 The process of integrating natural capital information Entities Financial institutions References Annex 1: Examples of Measure and value Apply stage: What next? Scope stage: What? valuation techniques stage: How? Frame stage: Why? Introduction 13

16 Frame stage Flexibility across types of analysis A natural capital analysis is likely to resemble one of five types (see table 1.3). You may choose combinations of analysis. For example, if you wish to demonstrate active engagement with your investees, you may begin by analyzing total value across your portfolio, then use the results to engage with stakeholders (e.g., investee companies) and finally communicate findings to the public. Table 1.3: Types of natural capital analysis Assessment of risk and opportunities Providers of financial services are exposed (both positively and negatively) through the direct natural capital risks and opportunities of the entities (companies, activities, assets, etc.) they engage with. Improved understanding, measurement, and valuation of natural capital impacts and dependencies can help to better inform decisions, and thus provide better returns, in the finance sector. Comparison of options Natural capital assessments provide information to compare options, and can help to assess and balance expected profitability against risk exposure. Natural capital assessments provide actionable and reliable information to allow comparison of natural capital-based risk and opportunity and to understand trade-offs. Engage stakeholders The finance sector has a crucial role as a driver of change. Financial institutions can use natural capital assessments to engage with stakeholders (such as investees, suppliers, clients, and the public) to encourage greater attention to, and awareness of, natural capital. Estimate total value and/or net impact Natural capital assessments can provide actionable information about the total value/net impact of individual entities and of portfolios. Total contribution to society can be used to consider the social value of financial activities over time. It might also be used to assess the value at risk due to portfolio composition. Communicate internally or externally Natural capital assessments generate and organize information using a systematic, comprehensive, globally acceptable framework. This can be used to enhance transparency both internally and externally. 1.5 Actions 1. Identify which natural-capital related risks and opportunities might be relevant, now or in the future. The examples in table 1.1 may be helpful. 2. Using the examples of additionality in table 1.2, consider how the natural capital approach might help you address some potential risks and opportunities. 3. Of the types of natural capital analysis in table 1.3, consider which might be of most interest within your financial institution. 1.6 Outputs After completing the Frame Stage, you will have the following outputs: An understanding of the business case for considering natural capital information in decisions. Knowledge of how a natural capital assessment can benefit you. Potential types of analysis and uses of their results. 14

17 1.7 Case Studies Case study examples are used to illustrate how you can use the information created from this Stage to inform your decision making. Table 1.4: Case studies for the Frame Stage Context Understanding the business case for natural capital How a natural capital assessment benefits you? How might the results be used? Bank Bank is a signatory to the Equator Principles. The bank s project finance team is reviewing a funding request from one of its clients for a major natural gas project comprising: A gas extraction field A gas pipeline (400 km) An onshore gas liquefaction plant The onshore gas plant will be located close to a UNESCO World Heritage marine site. The bank is concerned about the effects of the project on biodiversity, and hence its acceptance by the UNESCO committee. As a signatory to the Equator Principles, the Bank cannot afford the reputational risk of investing in a UNESCOdisapproved project. The bank will conduct an assessment to determine the net impact of the project and will consider data from this assessment in its decision on whether or not to fund the project, and what mitigation measures could be adopted for it to comply with UNESCO expectations, and therefore allow the bank to proceed with investment. The main benefit for the bank is to have actionable information about the viability of the project and associated risks to the neighboring marine UNESCO site. They hope this information will help to design mitigation measures, and therefore make the project an attractive, compliant investment. Bank wants to understand the risks and impacts of the project on the biodiversity and mitigation options, as well as to assess whether project impacts would be acceptable to the UNESCO committee, and to the bank itself as a signatory to the Equator Principles. Asset manager Triple Capital Triple Capital is a signatory to the Principles of Responsible Investment (PRI), with long-standing commitments to account for environmental, social, and governance (ESG) issues in its investments and to engagement with the companies and other assets it invests in. Triple Capital is exploring whether natural capital assessment(s) can help it to better understand and manage natural capitalrelated risks and opportunities, and also help it to respond to those clients with a particular interest in natural capital. The fund manager will conduct an assessment to identify risks and opportunities, by focusing on its emerging market listed equity portfolios. Improvement of risk management (by enhancement of inclusion/ exclusion and overweighing/ underweighting criteria). Also, enhancement of engagement and voting practices. If the exploratory assessment is useful, Triple Capital will use future assessments to inform investment decision-making and portfolio risk management processes. Assessments will also guide identification of engagement opportunities. Capital Insurance Capital Insurance provides business interruption insurance to many of its clients. This insurance frequently covers losses as a result of flooding or other extreme weather events, many as a result of climate change. Capital Insurance routinely assesses weather- and floodrelated risk as a standard part of its due diligence processes. It now wants to explore whether it is fully accounting for its exposure to climate change-related risks at the portfolio level and how it might improve processes for assessing these risks. Related to the increase in extreme weather events, Capital Insurance also wants to explore the extent to which its portfolio is dependent on natural flood defenses, and the value of this dependency. The insurer will conduct an assessment of how climate change is expected to affect flood risk profiles and of potential future payouts to the companies it insures. It will also look specifically at the business value of natural flood defenses across its portfolio. The insurer will be able to identify regional and sectoral risk exposure and improve pricing of insurance. Depending on the value of dependency to natural flood defenses, the company may also inspire preventative action to limit its future risk. Capital Insurance wants to understand how significant climate change is as a portfoliowide risk, to inform its thinking on whether it needs to pay more attention to this sort of systemic risk in its due diligence and decision-making processes, particularly regarding the management of flood defenses. References Annex 1: Examples of Measure and value Apply stage: What next? Scope stage: What? valuation techniques stage: How? Frame stage: Why? Introduction 15

18 Scope stage SCOPE STAGE What? The Scope Stage helps you define what should be included in your assessment. In this Stage, you will define your objective and identify the audience for the results of your natural capital assessment. The Scope Stage also guides you through a series of interrelated decisions to scope your assessment including identifying assessment focus and boundaries. Scoping is an iterative process where decisions are refined over time, both during the scoping process and during the later Stages of the assessment. Stage 02 Sections Scope stage 2.1 Decide the objective 2.2 Identify the target audience 2.3 Define the scope 2.4 Actions 2.5 Outputs 2.6 Case studies 16

19 02 Scope stage 2.1 Decide the objective Once you have decided to conduct a natural capital assessment, and you have defined the analysis type, you then need to define a specific objective. Table 2.1 includes some examples of objectives and groups these by type of analysis. If this is your first natural capital assessment, consider starting with a narrower or more manageable objective, to help yourself get familiar with the process. For example, use an issue for which you already have some data or have internal experience. Table 2.1: Examples of objectives for different types of analysis Type of analysis Assess risk and opportunities Compare options Stakeholder engagement Estimate total value and/or net impact Communicate internally or externally Sample objectives To estimate the natural capital-related risk by economic sector, across a number of different regions, to inform future portfolio risk. To assess the market potential for new natural capital-related products (e.g., investment products linked to sustainable tourism, or products related to sustainable coastline protection). To analyze how portfolios perform under different scenarios (e.g., different low-carbon transition pathways). To compare different investment opportunities, (e.g., two different agricultural developments with respect to their dependency on ecosystem services such as pollination of crops or water security). To assess the dependency on water of a portfolio of manufacturing facilities in a droughtprone area, with the aim of engaging with the most exposed companies to help them reduce dependencies. To work with a bank s portfolio of farmers to help them improve their resilience to natural capital changes and to reflect this in their risk ratings. To quantify the financial significance of the biodiversity and deforestation-related impacts of a new mining project, as part of a wider project risk assessment or due diligence process for a client. To assess the impact of drought scenarios across a portfolio. To create an investment fund with a net positive impact on natural capital, covering water, carbon, and biodiversity. To ensure that the entire financial institution has a net positive impact on natural capital. To build internal knowledge and understanding of natural capital, so that key decisionmakers within the organization understand the degree to which future revenues, costs, and success rely on natural capital. To gather information on the natural capital impacts and dependencies in an investment portfolio to enable reporting to investors and stakeholders. References Apply stage: What next? Scope Stage: What? Frame stage: Why? Introduction Measure and value stage: How? Annex 1: Examples of valuation techniques 17

20 Scope stage 2.2 Identify the target audience It is important to identify and agree for whom you are carrying out the assessment (the target audience) as this helps to focus the assessment on the type of information, or appropriate degree of confidence, needed. The target audience may simply be the person who commissioned the work but is usually a wider group or groups. Table 2.2: Examples of target audiences Internal target audiences may include: Board directors Senior management (e.g., CEO, CIO, CRO) Credit committee Portfolio managers Account managers Risk management teams Investment, credit, or insurance analysts ESG teams Communications teams Employees External target audiences may include: Shareholders or investors Deposit holders Civil society organizations (e.g., NGOs, labor unions) Entities or projects in which the organization has a financial interest ESG research and ratings agencies Governments or financial regulators Clients, customers, or members of pension funds Local communities and other parties affected by the impacts or dependencies of the entity or portfolio in question Identifying a target audience is different from selecting groups for stakeholder engagement. Stakeholder engagement is used to inform a process (as an input) rather than being the intended audience for the output. There can of course be overlap between these two groups. When identifying your target audience, you should consider: Time requirements. For example, if using a natural capital assessment to inform a board-level decision, planning should incorporate the time needed to achieve the necessary level of confidence/accuracy. The level of verification and validation needed. For example, when deciding to use the information to inform regulators, a verification process may be necessary. The depth of detail and format of the output. For example, when informing local communities and NGOs, transparency in data sources and assumptions will help to create trust. 18